Buying Options
by Rick Thachuk

Beginning traders often are urged to limit their initial trading activity to the purchase of options – buying a call option if prices are expected to rise and buying a put option if prices are expected to fall. Options have the primary advantage of limiting downside risk: For any option that is purchased, the most that can be lost is the premium (or cost) of the option plus commission and other transaction fees. However, some challenges do exist when it comes to putting this strategy into practice. An immediate one is translating the string of numbers that you might pull down from the Internet into a sensible option price.

Reading Option Prices

Generally, option prices are quoted in ticks or minimum price fluctuations. The dollar value of a tick can vary from market to market and is described in the contract specifications for that market. This, in turn, is set by the exchange on which the contract trades. At first, you will have to study the tick values, but in time you will know the common ones by memory. Let’s look at some typical option prices as examples.

Gold Options:
One tick in the gold options market is 10 cents per ounce and has a value of $10. With June gold futures at $383.50 per ounce, for example, the June gold call option struck at 385 may be trading at $4.10 per ounce, or 41 ticks, which is equal to $410.

Bond Options:
One tick in the bond options market is 1/64 of a point and has a value of $15.625. With September bonds futures at 107-29, for example, the September bond call option struck at 108 may be trading at 1-38 or 102 ticks equal to $1,593.75. (Bond option prices are expressed in 64ths of a point, so 1-38 means 1 + 38/64 = 102/64.)

Sugar Options:
One tick in the sugar options market is 1 cent per lb. and has a value of $11.20. With July sugar futures at 7.52¢ per lb., for example, the July sugar call option struck at 750 may be trading at 36 ticks, which is equal to $403.20.

Cocoa Options:
One tick in the cocoa options markets is $1 per ton and has a value of $10. With July cocoa futures at 1351, for example, the July cocoa call option struck at 1350 may be trading at 67 ticks, which is equal to $670.

When pulling option prices from the Internet that originate from the exchanges themselves, a decimal may or may not be shown in the option price. This is a feature of the price reporting software of the exchanges, and it will make interpreting the price a little more difficult. However, if you know what price to expect, then it won’t present a problem. In most cases, you can disregard any decimal that may exist and consider the number to be in ticks. Multiply this number by the tick value to calculate the option price.

When calculating option prices, use the following as approximate guidelines for checking your answer:

* Call options become less expensive the higher the strike price.
* Put options become more expensive the higher the strike price.
* Call and put options become more expensive the longer the time to expiration.
* For most markets (not including the equity index markets), the value of an at-the-money call or put option with one month to expiration usually falls between $400 and $1,500. If your calculation produces a price far outside of this range, you may have an error.

After a little practice, you should be able to read option prices quickly and easily and then you can move on to the next step: Selecting the proper strike price.

Selecting the Proper Strike Price

For any call or put option of a specific contract month, a list of options is available each having a different strike price. Consider, for example, call options on July cocoa futures. Assume that it is early May and that July cocoa futures are trading at $1306. Below are sample prices of a series of July cocoa call options. The price for each is shown in ticks, as it is customarily quoted, and then in dollars. Each tick in cocoa is worth $10.

July Cocoa Call Options

Strike Price (ticks) Price ($)
1250 61 $610
1300 33 $330
1350 18 $180
1400 11 $110

Note that the prices of these call options vary depending upon the strike price. The lower the strike price, the more expensive the call option. This makes sense because a call option gives the holder the right to acquire the underlying futures contract at the strike price. A lower strike price means the option holder can acquire the futures at a cheaper price, but the option buyer must pay for this privilege by paying more money for the option. The two almost exactly offset each other, so there are no quick and riskless profits that can be made. This is ensured by professional arbitrage within the trading pit.

A trader who expects cocoa to rise by the time the July option expires will buy a cocoa call option. The question is: Which one?

When selecting an option, the trader must first determine how much he wants to spend (risk). The most that an option buyer can lose is the cost of the option plus transaction and other fees. For example, if a trader wants to spend no more than $500 on a July cocoa call option, then the 1250 strike option would be excluded from the list because it is too expensive.

The trader can then choose among the financially affordable options by comparing the various strike prices with the trader’s forecast of the price of the underlying futures contract. For example, the July cocoa options expire in early June. If the trader thinks that it is unlikely that July cocoa futures will rally to over $1400 by this time, then he should not buy a call option with a strike price of 1400 or higher.

Let’s say that the trader expects July cocoa to rise to 1385 by the time the options expire. The 1300 call option will be worth $850 at expiration, generating a net profit of $520 ($850 – $330 = $520) or a 158% return. The 1350 call option will be worth $350 at expiration, generating a net profit of $170 ($350 – $180 = $170) or a 94% return. In this case, the option with the 1300 strike price provides the better investment. The result will, of course, vary depending upon the futures price that is expected. For example, if July cocoa is expected to reach $1435 by option expiration, then the rate of return on the 1300 call option is 309% and on the 1350 call option, 372%.

Choosing an option often involves a trade-off between these two factors. In other words, the trader must balance risk (or cost of the option) with potential return. In this regard, choosing an option is no different than any other investment decision.

In the cocoa example, there is no clear choice between the 1300 and 1350 call option, although the 1300 call is probably the better investment over most bullish scenarios.

As a general rule of thumb, a near- or at-the-money option (an option whose strike price is close to the price of the underlying futures contract) is usually a good choice. In contrast, beginners should be cautious about buying options that are deeply out-of-the money. Despite its appeal, such a strategy rarely leads to consistent profitability, and this is the next topic.

Beware the Deep Out-of-the-Money Option

A call option is out-of-the-money if the strike price is above the market price of the underlying futures contract. A put option is out-of-the-money if the strike price is below the market price of the underlying futures contract. In both cases, the further away the strike price is from the market price, the deeper the option is out-of-the-money. For an option to have value upon expiration, the futures price must be above the strike price in the case of a call option, or below the strike price in the case of a put option. The deeper out-of-the-money the option is, the more the futures price must move by the option’s expiration. The larger the needed movement, the less likely it will occur and the more likely the option will expire worthless.

Deep out-of-the-money options have a low cost and the percentage payoff can be tremendous if – and that’s the important word – the underlying futures contract moves beyond the option’s strike price by the time the option expires.

Unfortunately, in most cases, the underlying futures fails to move sufficiently and the deep out-of-the-money option expires worthless. The premium paid, although relatively small, is lost. This is so widely recognized that the Commodity Futures Trading Commission, the federal regulator of the U.S. commodity markets, requires in the Options Disclosure Statement given to every potential options customer the following disclosure: “Customers who are contemplating the purchase of deep out-of-the-money options should be aware that the chance of such options becoming profitable ordinarily is remote.” Furthermore, the National Futures Association, which regulates marketing and communication with the public, requires that brokers adequately monitor the solicitation and sale of deep out-of-the-money options.

Therefore, customers need to balance their investment portfolio with other strategies that have a higher likelihood of becoming profitable. While there is certainly nothing wrong with buying deep out-of-the-money options on occasion and during those times when a large futures price movement seems imminent, the beginner should not allocate all of his trading capital to this strategy.